All that Jazz: New CDO for managers who like improvising

Deutsche Bank is putting the finishing touches to Jazz, a new collateralized debt obligation that will provide some CDO investors with far more flexibility than they have hitherto enjoyed. The deal is managed by AXA Investment Managers, a French firm that favors musical names for its deals, and claims to be the first transaction that allows fund managers to fluctuate between cash bonds and credit default swaps.

The idea of such a structure has been floating around the market for the last six months but this is the first CDO to actually implement it in full. In the past, rating agencies have not been comfortable with hybrid structures and the time it takes to make sure that the default language used in such deals is acceptable.

"It's a very innovative transaction that combines what formerly were two separate types of transactions, cash flow CDOs and synthetic CDOs," said George Sun, a director in the structured finance ratings group at Standard and Poor's.

The deal's hybrid structure required S&P to find an equally innovative way to analyze it. "Using both what we've done in cash flow CDOs and also in synthetic CDOs, we've had to mix our criteria to get comfortable with this deal," Sun said, adding that there are still details to be worked out before the agency can publish a pre-sale report.

While Jazz may not be the first truly managed synthetic CDO to hit the market, it is the most flexible to date and the first from a bulge-bracket manager. There are a handful of deals in, or being prepped for, the market that are also structured to combine cash flow CDO features and synthetic CDO features. There have also been deals that offer some of the benefits of a managed CDO without quite as much flexibility.

"It's a little bit of an illusion because there have been synthetic CDOs prior to this where the manager could substitute credits," said Alex Reyfman, a director in the credit derivatives structuring group at Goldman Sachs in New York.

"Where the right to substitute turns into active management is not well defined." Jazz, he points out, is clearly a managed deal.

Capturing spread synthetically

The Jazz deal also frees mutual fund managers of the restrictions that prevent them from going short, thus giving them the opportunity to buy protection against short-term spread movement. Until now, only hedge funds have had this kind of freedom.

"Hedge fund managers don't like CDOs because you can only time the deal once, meaning you have to buy all the collateral within a certain amount of time once you're in," said Jeffrey D'Souza, director of global credit derivatives at Deutsche Bank in London. "If you've done it at the wrong time and spreads widen more, you've lost an opportunity." The Jazz deal eliminates the timing issue, which is an attractive feature in a market that is generally expecting spreads to widen over the coming months.

As it stands, mutual fund managers have no way to express a view on how spreads might move. With Jazz, a manager that thinks spreads are going to widen in the short term can buy protection in the credit default swap market with a view to unwinding that position when spreads widen.

"Now you have the ability to actually generate some trading gains on the deal and take advantage of that type of opportunity," said Deutsche's D'Souza. "That gives you a huge amount of flexibility."

Quest for innovation

While each new CDO that comes to market bears a new quirk, players agree that the Jazz CDO is a major step in terms of structure. Some players are worried, however, that the quest for innovation might spiral out of control.

"The key to this market is going to be more on understanding manager needs and structuring in a way that gives maximum flexibility to the manager rather than just structure for structure's sake," said Goldman's Reyfman.

Goldman has also been working on a hybrid structure similar to that of Jazz, approaching it from the angle of what structure would be most appropriate to a particular manager's expertise.

AXA, which also runs the Concerto series of high-yield funds, has expertise in a number of different asset classes, he said, but whether they will be able to take advantage of this very far-ranging flexibility remains to be seen.

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